Getting to 2.4%: Hidden Levers & Skewed Incentives

Monday’s Budget will hopefully include further details of how the government intends to reach its goal of 2.4% of GDP being spent on research and development by 2027.

This target, announced a year ago in the 2017 Industrial Strategy, would bring the UK up to OECD levels. Compared to where we stand at present – 1.7% of GDP – it’s a pretty steep jump, that requires redirecting an additional £15 billion or so per year towards research and development.

It’s pretty unusual to achieve this kind of target. But 10 other countries have achieved a similar feat in recent times – including Korea between 2003 and 2013, and Estonia between 2001 and 2011 – so at a very crude level, it seems achievable.

However, it will require continued political will to defend (and likely further increase) public R&D spend in the face of competing interests, as well as the intelligent and creative use of public funds to leverage private sector resources as well as foreign investment.

Moreover, it will require a better understanding of the ‘hidden levers’ that affect R&D, and the skewed incentives which inhibit it.

From where will the increase come?

One key point is the role of businesses. Businesses are main funders and performers of R&D in the UK, accounting for two thirds of gross domestic expenditure on research and development (£22bn out of £33bn). It is also the case that, in recent years, the majority of growth in UK R&D has come from the private sector.

That is not to underestimate the importance of public sector contributions – in terms of funding R&D in higher education and scientific research institutes (some of which ‘crowds-in’ additional private sector R&D); investing in the complementary assets required to unlock value from R&D; and also in terms of incentives for the private sector (such as tax reliefs or grants).

But in each of the 10 cases referred to above, the increase was led primarily by business, and the same would likely have to be true in the UK. We therefore need to focus on what drives or inhibits this.

Why aren’t firms innovating more already?

Studies suggest that the long-termaverage internal rate of return of business R&D may be around 30 per cent. Given that this is greater than the cost of capital, why are firms not already investing more, even if it means raising funds to do so?

Economists have numerous theories but one obvious answer is that firms don’t base decisions on long-term, cross-sectoral averages, but on a project-by-project basis, where return on investment is often inherently difficult to measure, necessarily uncertain, diffuse and delayed.

For example, there is clearly benefit in oil companies improving their reservoir models, but this may be the result of numerous projects, with the resulting knowledge spread across multiple parts of the organisation and used in different ways. Directly translating this into increased profit is very difficult indeed.

Other impact may be literally invisible: a nuclear power firm undertaking R&D in order to understand possible failure modes, for instance, may reduce the risk of some future catastrophe. Undoubtedly this is socially valuable, but pricing this is again hard.

A second problem may be that the long-term average rate of return no longer holds for our major R&D-intensive firms. UK BERD is dominated by the pharma industry, yet there has been a downward trend in rates of return for R&D from over 10% in 2010 to just around 3% in 2017. Together with the fact that the time to market for new therapeutic drugs is often well over a decade, there is little doubt that our top R&D spenders face an extremely challenging research environment.

Additionally, for some firms, the cost of capital is actually much greater. In particular, companies whose assets are mostly intangible (know-how, branding, social networks) find it very difficult to borrow, since lenders struggle to treat these assets as securities.

Longtermism and incentives

A different reason could be that short-term priorities override long-term plans. Individual executive incentives can sometimes run counter to the long-term interests of their firm, inducing managers to cut R&D or delay valuable projects in order to meet earnings targets; or when approaching vesting period for equity and options.

Our own analysis of the FTSE350 (forthcoming) suggests that part of the problem is the metrics used in incentivisation plans: only 37% of plans include any measures related to innovation (such as new product pipeline or process improvement). Only 2% of incentive schemes directly reference R&D spend.

Far more common are metrics such as total shareholder return and earnings per share. In the long-run, R&D and other innovation will boost these. However, there are many other ways to improve these metrics, and in the short-run, these are often more easily met by cutting spending than by increasing it.

Long-term incentivisation plans are not much better: again, very few reference metrics which require R&D spend, and most are typically three years – not ‘long-term’ by the standards of many R&D projects.

These firm-level factors are potentially exacerbated by the changing nature of equity markets: institutional investors tend to increase R&D spend and, perhaps more importantly, the productivity of that R&D, partly through giving managers the confidence to place longer-term bets. However, over the past two decades, such institutional investors have largely been replaced by overseas investors, arguably reducing the quality of this shareholder engagement.

What should Government do?

How can Government encourage firms to increase their R&D spend, and what would we like to see on Monday?

One of the major levers over business is corporation tax. This matters both for attracting inward BERD (low rates have undoubtedly been a major draw for ‘big tech’ into Ireland, as we’ll discuss in the subsequent blog). But it likely also matters for domestic firms: higher corporation taxes have been shown to have significant negative effects on firms’ innovation activity in the US.

However, the Governments’ 2010 Corporate Tax Roadmap already aims ‘to create the most competitive corporate tax regime in the G20’, reducing the main rate to 17% by 2020. Would there be any benefit in going further still, perhaps matching Ireland (at 12.5%) or even Hungary (9%)? Maybe – but it would be a gamble, since we’ve limited knowledge about how it would actually impact public finances or R&D spend.

Regulation is another tool. We’ve written previously about the need for ‘anticipatory regulation’ as an enabler of innovation and emerging technologies, and will return to this in more detail in our next blog (and in a forthcoming paper). However, continued support for the Regulators Pioneer Fund would be welcome.

Relatedly, we need to build evidence of what incentives work for what sorts of firm, in order to ensure that public money is used as wisely as possible. The benefit of Patent Box has been questioned, for instance, and there may be more effective ways to redirect this support. But we’d also like to see more incentives schemes place greater emphasis on experimentation and policy learning, as does the BEIS ‘Business Basics’ programme.

(For Nesta's part, we're working to identify the most effective ways of supporting businesses to innovate though our Innovation Growth Lab which focuses on experimentation and rigorous evaluation of policy interventions.)

With regards to pharma, if we believed that R&D returns in the sector may not recover, part of the response would likely entail an accelerated transformation of the sector's R&D model as well as a shift towards greater investment in other forms of healthcare innovation, such as behavioural, social and digital health, which may conceivably also generate greater social impact for equivalent spend. (Dedicated funding for digital health is something that we might expect to see in Monday’s Budget, irrespective of the fortunes of big pharma).

We would also like to see whether there are ways of reforming corporate governance to encourage greater long-termism. Part of this could include changes to executive remuneration, but market-based mechanisms will also be important: better tools for measuring the impact of R&D, coupled with greater awareness of the typical returns, would hopefully encourage greater shareholder scrutiny and, in turn, more long-termist behaviour.

There isn’t a silver bullet for R&D, and in the coming weeks we will be exploring various issues further – including the role of foreign-owned firms and how we ensure that, in achieving the 2.4% target, we don’t miss the bigger point. However we plan to get there, public funding for R&D will inevitably play a major part, and so we’ll be watching Monday’s Budget closely not only for continued commitment to the quantity, but also for more detail on what and where this is invested.

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